:: 1031 Exchange in Layman Terms ::
Capital gain from the sale
of real estate or personal property held for investment
purposes can be deferred if the
property is exchanged for
like-kind property of same or higher value. This is
ordinarily accomplished through selling the investment
property and placing the funds with an intermediary until
the replacement property is purchased. IRS also allows
reverse exchange transactions effectively enabling the
purchase of the replacement property prior to the sale of
existing investment property.
Forward Exchange: You sell your property first and then buy a replacement property.
Reverse Exchange: You buy replacement property first and then sell your existing property.
Process:
-
You sell your existing property
-
Place funds with an intermediary
-
Identity replacement property within 45 days and complete transaction within 180 days.
Benefits: Simple transaction requiring no out of pocket cost if funds are kept with the trustee for more than 30 days. Otherwise costs $500 per transaction.
Drawbacks: In a seller's market when properties for sale are in short supply, it becomes difficult to identify a property within 45 days and complete a transaction within 180 days. The process also puts you in a bind to purchase a property within a limited time, taking away your ability to find a sound investment property and limiting your negotiating advantage.
:: Reverse Exchange ::
Process:
-
You identify a property for purchase.
-
A trustee purchases the property for you.
-
You lease the property from the trustee at cost.
-
You sell your existing property.
-
Pay the trustee to take the title of replacement property.
Advantage: No time constraints. You have all the time in your hand to identify and purchase a replacement property. You have the luxury of finding a sound investment property and time to negotiate a transaction. While you are selling your existing property, you have a full use of replacement property at cost.
Disadvantage: Costs a minimum of $2,500 to complete the process, but the full transaction fee is agreed in writing before proceeding with the transaction.
QUALIFIED PROPERTIES
The classification of properties exchanged determines if the property qualifies for Section 1031 treatment.
A. The IRS's 4 classifications of Real Estate:
Property held for personal use. (Personal Property)
Property held primarily for sale. (Dealer Property)
Property held for productive use in a trade or business. (Business Property)
Property held for investment. (Investment Property)
The last two qualify for Section 1031 tax deferral, the first two do not. Both the property received and the property sold must be of "Like Kind". It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.
B. Like-Kind Property
Like-kind refers to your use of the property and not to its grade or quality.
"1031" property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc. (See page 14.)
Property held outside the USA and its territories does not qualify for exchange with property held within the USA.
C. Partnership Interests
Your interest in a partnership cannot be traded for an interest in another partnership.
Exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.
D. Transfer Between Spouses
There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for nonrecognition under the provisions of Section 1031.
E. Sale/Lease Back As An Exchange
A lessee’s interest in a lease with a term of 30 years or longer in real property is considered like-kind to other real property. In addition, property which is subject to a lease can be, even if the lease is for a term of 30 years or longer, the subject of a tax free exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.
F. Business Assets
The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).
G. Vacation Homes & Properties
This type of property does not qualify if it is used solely for personal use.
It may qualify if rented, and must pass a use test each year.
:: Commonly Asked Questions ::
For those that need a clearer picture of how a tax-deferred exchange is structured, we've compiled a list of commonly asked questions. If you have questions about anything below, or other matters not addressed here, please give us a call and we would be happy to clarify.
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Constructive Receipt - In a simultaneous exchange of two properties, is an intermediary required?
A: The IRS, supported by a court decision, treats escrow agents as being under the control of the exchanger in a transfer between two exchange escrows without use of an intermediary. The transaction is therefore deemed taxable in their view.
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Multiple Use - My property is my primary residence and has two rental units attached. Does 1031 apply?
A: Section 1031 applies to the rental units (investment or productive trade or business), but not to the primary residence (Section 121 applies there). By putting the mixed property into two escrows (home and rental units) so that the 1031 funds can be traced cleanly, the 1031 should work.
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Vacation Home - The real property I am receiving will be a vacation home. Does that qualify for 1031?
A: So long as you can deduct your expenses (personal use is less than 14 days or 10% of rented days), vacation homes qualify for 1031 treatment.
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Change of Use - I am going to move into my replacement property soon so the replacement property will become my primary residence. Is that okay?
A: It would have been if you had not asked the question. A genuine change of intent does not disqualify an exchange. For example, buying replacement property for rental income and investment but having a true change of heart after acquiring it and deciding that it will become your primary residence would be okay. The determining factor is your true intention at the time of the exchange. Therefore, as much support you can muster for your position the best (a loan for your replacement property should not be an owner-occupied loan; arrangements should be made to rent the replacement property following escrow, etc.)
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Investment Intent - Since I cannot intend to move in, then I am going to give the replacement property to my children (because I know they will let me live there.) Is that okay?
A: If you intended to hold the replacement property for investment and later decide to give it away, 1031 would apply. But acquiring the property with the intent to give it away disqualifies the exchange because you have no intention to hold it for investment.
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Related Party - Last year I swapped properties with my daughter and her husband and now they have to sell the home. That does not have any effect on me, does it?
A: Your exchange will be set aside (and the swap fully taxable) if within two years of the exchange with any related party either party sells the property received. So your daughter's sale will cause you to retroactively incur tax on the exchange.
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Release of Cash - I have got to use cash from the sales proceeds, which the intermediary is holding for me. What will happen?
A: Once the intermediary holds the exchange proceeds, exchanger cannot receive cash or the entire exchange collapses. Cash can be disbursed from escrow (it will be taxable as boot) without destroying the exchange. Theoretically (with a Tax Court case supporting the theory), pulling cash out of the intermediary exchange account after completing one purchase but failing to complete the identified other one or two disqualifies the first purchase.
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Selling and Escrow Expenses - Can I have commissions, escrow charges, loan fees and so forth paid out of escrow?
A: Yes, but the IRS is likely (with support of the American Bar Association Position Paper) to tax you on your loan fees and any other monies relating to the replacement property, which would have to be capitalized. However, that should not disqualify the exchange.
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Late Identification - I did not identify my replacement properties within 45 days. Will my exchange be disqualified?
A: There is no more arbitrary and unfair rule in the Tax Code than the one requiring identification of replacement property within 45 days. Until a court decision softens it with some rule of reason (do not let it be your case), the IRS is absolutely strict about the 45-day rule. The IRS assesses fraud penalties when the rule is intentionally violated and those penalties have been upheld in Tax Court (in that case the taxpayer was also prosecuted criminally for giving a false statement to the IRS auditor, the false statement being the backdated identification form.)
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Step Transaction - I am going to exchange two building sites with a developer for one of his other properties. I might have him build a home on one of the properties he gets from me and then swap it back. That's okay, right?
A: Technically, those two transactions would be exchanges, which could qualify for Section 1031 (assuming each party had investment intent.) However, the IRS would not hesitate (and neither would the courts) to set the transaction aside because all that has happened is you traded a piece of property for improvements on your other property. Improvements alone are not eligible for 1031 treatment.
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Improve to Sell - I am acquiring a fixer-upper in an exchange, which I will remodel and sell off. Is that okay?
A: The cases are all over the place on this issue. The theory is clear: The taxpayer must receive the property with the intention of holding it for investment. Cases have found that the taxpayer had proper investment intent even if there was a double escrow of the replacement property (there was clear evidence of a change of intent during the escrow.) Yet, a company, which held a replacement property for 11 years, was held not to have investment intent because during that time it was shown on the company books as "work in progress", so the IRS successfully argued that the taxpayer always intended to improve and sell it.
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Improvements During the Exchange Period - I am getting property in an exchange that needs improvements and I would like to pay for that work out of my exchange proceeds. Is that okay?
A: If the intermediary is willing (and Replacement First is), it can hold title to the replacement property and fund the repairs and improvements from the exchange credit. However, the property must be conveyed to you before the 180 days expires. You cannot use the exchange proceeds to pay for improvements, only the seller of the property or the intermediary can.
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Refinancing Around the Time of the Exchange - I need to pull a lot of equity out of this deal and not pay any tax on it. How can I?
A: Generally, no one is taxed on proceeds from a borrowing because you have to pay them back. Therefore, borrowing money against either your relinquished property or replacement property should theoretically be okay. However, it is much more dangerous to borrow against the relinquished property shortly before the exchange (because you know you will not have to pay the money back, the exchange proceeds will do so.) In effect, when borrowing against the relinquished property, you are getting an early disbursal of the exchange equity (a Tax Court case so holds.) On the other hand, borrowing against the replacement property should be perfectly okay because that is a debt, which the taxpayer expects to have to repay. If your trouble is deep enough that you cannot hold out until the exchange closes, then document your borrowing against the relinquished property so that it does not relate to the pending exchange and has some independent business reason causing the borrowing.
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A Partnership Winding-Up - Three of us formed a partnership back in the 1970's and bought a piece of property, which we are now selling. We are each going to buy separate properties with our share of the proceeds. Okay?
A: The problem here is "investment intent": if the partnership gathers the replacement properties and then distributes them in liquidation to the partners (a "swap-drop"), the partnership has no investment intent with respect to the replacement properties. If the partnership distributes the relinquished property to the partners as tenants-in-common and they then exchange their tenancy-in-common interest for their respective replacement properties (a "drop-swap"), the partners have no investment intent with respect to the relinquished property. Sensibly, the partner should get the benefit of the partnership's investment intent and vice-versa. The only cases in the area have been the condemnation 1033 context (where one case allowed a drop-swap where the swap occurred 18 days after the drop.)
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Limited Liability Company - My lender on the new property requires it be held in a limited liability company with no other activities or assets in it. Is that okay?
A: Yes. The IRS has recognized in Private Letter Rulings in the last couple of years that an individual property owner can form a limited liability company (with only that person as a member and probably with a spouse as a member) and still qualify for a 1031.
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Reverse Exchanges - I found a great property I have to buy all-cash in 10 days. But I want to fund it from a sale of some property I own. How do I do that?
A: The IRS has issued Revenue Procedure 2000-37, which permits reverse exchanges under safe harbor guidelines. The revenue procedure follows the format of regular delayed exchanges (the relinquished property must be identified within 45 days of the purchase of the replacement property and the closing of the sale must occur within 180 days.) The use of an exchange accommodator (Replacement First, Inc.) is very important here. Replacement First will form a corporation or limited liability company to hold the replacement property (or the relinquished property) and will enter into a lease agreement with you to provide that you pay all the property bills and manage it according to your requirements.
No you do not, however you will be taxed on the amount you don’t spend. Unused proceeds are known as "boot" and are taxed on their face value at the capital gains tax rate.
You can receive unused proceeds at anytime after you have acquired each one of the properties identified in your 45 day identification. If you do not acquire all of the properties identified in the 45 day identification, then
the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.
Yes, you can sell your relinquished property using a Note & Trust Deed to finance the sale. It is possible for the promissory Note and Trust Deed to be made out to the "Exchanger". If this is done the Note is taxable and may not be used to buy replacement property.
However if the Note & Trust Deed is made out in the name of the Qualified Intermediary. You have four choices on how to use it to buy replacement property:
You can use it to acquire replacement property by trading it to the "Seller " for part of the equity in the new
property (that is spend it like it was cash).You can instruct the Qualified Intermediary to sell the note on the open market (you can negotiate this sale
or have the Intermediary do it) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It is less desirable because of the discount given on the
sale of the note.A party related to the "Exchanger" such as a closely held corporation or relative can either purchase the Note from the Qualified Intermediary, or provide financing so that the Qualified Intermediary receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction.
You can wait until the end of the exchange and receive the note back from the Intermediary. This will result
in the note becoming "boot" and it will be taxable. However, you will only have to pay tax on the amount received each year.
There are two ways that new construction is handled in an exchange:
You contract with a builder to purchase a property which will be completed, and closed, prior to the end of the 180 day exchange period. You can purchase the land prior to construction as one of your replacement properties, or you can purchase the land & building from the builder at the time of closing. This is the least expensive and easiest method for the exchanger.
You can contract to do what is known as a "Build-out Exchange". This is where the exchanger finances all or part of the construction. Through a special agreement with the Qualified Intermediary the builder draws on the exchange proceeds as certain steps of the construction are completed. This arrangement is much more complicated and risky for the Exchanger, and the Intermediary, and increases the cost of the exchange by $1,500 or more.
In either case the purchase and sale agreement should have language in it that requires the builder to bear responsibility for the exchangers taxes if the exchange fails due to the completion of the construction later than the required 180 day exchange closing period.
The safest way is to wait until after your "Relinquished" property has closed. The opening of escrow ( or notification to the closing agent) may constitute identification as the escrow agent is listed by the IRS as a person involved in the exchange {1.1031(k)-1(c)(2)(ii) example}, and if it is done prior to the closing of the "Relinquished" property it can shorten the entire exchange period to 45 days. It is a dangerous practice and does not speed up the "replacement" property closing. Replacement property is identified if it is designated as replacement property in a written document signed by the taxpayer and sent to the Qualified Intermediary prior to the end of the 45 day identification period. We will send you a form to fill in after your relinquished property closes.
Yes you can combine multiple relinquished properties into one replacement property. The rule here is that the first relinquished property to close starts the clock running for all the rest. All the relinquished properties to be combined must be closed within 45 days of the first one to close. The same replacement property is then identified for each relinquished property to be combined. Treas. Reg. 1.1031(k)-1(b)(2)(ii).
There are no hard rules here. What the IRS requires is that you show intent to use the replacement property as a rental.
Most of the tax attorneys that we talk to feel that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 exchange.
The trick here is to be able to establish the basis on the new property at the time of sale. The basis on the new property is the sum of the basis transferred from the old property, plus the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement
property. Additional Information and examples can be found on our website at:http://www.irs1031exchanges.com/manual/bookm4.shtml#V1
PROPERTY BASIS.
Section
1031 (like-kind exchanges) offer the opportunity to exchange one property for
another, and defer (not currently pay tax on) the gain until the new property is
later disposed of in a taxable transaction. In addition, there is no limit to
the number of times a taxpayer can take advantage of Section 1031 exchanges.
Brokers and parties to transactions can use Section 1031 exchanges to their
creative advantage when a party would not be willing to sell in a taxable
transaction, or when buyers are cash poor but have other business or investment
property, or will have no capital gains tax currently due because of Section
1031.
Section
1031 exchanges have been referred to by a variety of names such as: Starker
exchanges, like-kind exchanges, delayed exchanges, non-simultaneous exchanges,
and tax deferred exchanges. They all basically refer to the same thing, i.e.,
that tax on any gain can be deferred through an exchange until a future taxable
event occurs.
Tax
considerations that the taxpayer should consider when determining whether to
execute a Section 1031 exchange include the following: (1) in an exchange, the
basis of the new property is reduced by the amount of gain which has been
deferred; (2) Section 1031 "defers" tax on gain until a future point,
but generally does not avoid it; and (3) in some circumstances, it may be better
to "Sell" the property, pay the tax, "reinvest" the
proceeds, and get a higher basis with more depreciation as opposed to exchanging
under Section 1031.
The
following legal memorandum is intended as an introduction to this dynamic area
of real estate brokerage practice. Individuals who are contemplating an exchange
should first consult appropriate professionals who are experienced in the tax
and financial aspects of Section 1031 exchanges.
Q
1. What does Internal Revenue Code Section 1031 say?
A
Section 1031 says that when property is "exchanged" for other property
that is "like kind," some or all of the gain which is
"realized" (received) may not be "recognized" (taxed
currently). For example, if a taxpayer exchanges one income or business property
which has an adjusted basis of $50,000 and a value of $100,000, for another
qualified like-kind property valued at $100,000, s/he has "realized" a
gain of $50,000, but it would "not" be currently recognized as
taxable, due to the provisions of Section 1031.
Note
that Section 1031 cannot be used for property that is personal use property,
such as a principal residence. Section 1031 says that no gain or loss is
currently recognized if business or investment property is exchanged for other
like-kind property which will be held for use in a trade or business, as an
investment, or for production of income.
If
an exchange is made for property that is both like-kind and not like-kind, as
where an apartment building is exchanged for a fleet of trucks and an office
building, then some of the gain will be recognized (taxable) by the Internal
Revenue Service (IRS). (The trucks are personal property, unlike the apartment
building and the office building which are both real property.) In general, all
real property will be considered like-kind with all other real property, as long
as both parcels are U.S. real property held for use in a trade or business, as
an investment, or for production of income. This non-recognition by the IRS is
not necessarily permanent. More correctly, the gain is postponed or deferred
until a later taxable transaction. (See Question 6).
Q
2. What is the exact wording of Internal Revenue Code Section 1031?
A
"Sec. 1031 [1986 Code]. (a) Nonrecognition of gain or loss from exchanges
solely in kind.
In
general - No gain or loss shall be recognized on the exchange of property held
for productive use in a trade or business or for investment if such property is
exchanged solely for property of like-kind which is to be held either for
productive use in a trade or business or for investment.
Exception
- This subsection shall not apply to any exchange of
(A)
Stock in trade or other property held primarily for sale, . . .
(D)
Interests in a partnership . . .
Requirement
that property be identified and that exchange be completed not more than 180
days after transfer of exchanged property: For purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not
like-kind property if
(A)
such property is not identified as property to be received in the
exchange on or before the day which is 45 days after the date on which the
taxpayer transfers the property relinquished in the exchange, or
(B)
such property is received after the earlier of
(i)
the day which is 180 days after the date on which the taxpayer transfers
the property relinquished in the exchange, or
(ii)
the due date (determined with regard to extension) for the transferor's
return of the tax imposed by this chapter for the taxable year in which the
transfer of the relinquished property occurs . . ."
In
other words, the following requirements must be met in order for the property to
qualify for Section 1031 non-recognition treatment:
The
properties, both transferred (the downleg) and received (the upleg) must be
like-kind (for example, both must be real property);
both
properties must be held for use in a trade or business or for investment and not
primarily for sale;
both
must be tangible (real or personal) property;
it
must be an exchange, not a sale and reinvestment;
the
taxpayer must demonstrate an intent to exchange; and
if
the exchange is not simultaneous, the taxpayer must meet certain time frames for
identifying the upleg property and closing escrow. These time frames will be
strictly enforced. (See Question 3.)
It
is also important that the taxpayer does not have constructive or actual receipt
of money, cash equivalent, or any non-qualifying property or have the
unrestricted right to direct the escrow proceeds. This warning also extends to
the taxpayer's agent. For this reason, some sort of "qualified
intermediary" should be used to act on behalf of the exchangor in a delayed
exchange. There are strict rules as to identification and receipt of property.
(See Question 4 for rules as to identification of the upleg property.) If the
various rules are not properly followed, the whole transaction could become
currently taxable.
Q
3. What are the time frames for a "delayed" (non-simultaneous) Section
1031 exchange?
A
After disposing of the downleg property, the taxpayer must:
"Identify"
the upleg property within 45 calendar days of the transfer of the downleg
property. (See Question 4.)
Acquire
(close escrow on) the upleg property no later than the earlier of:
a.
180 calendar days after the downleg property is transferred, or
b.
the due date (determined with regard to extension) of the tax return for
the year in which the downleg was transferred away.
Q
4. What must a taxpayer do to "identify" the upleg within the 45 day
period?
A
A taxpayer must clearly identify in writing the property to be acquired. The
identified property must be unambiguously described. Generally, a street address
or legal description will suffice.
Under
Treasury Regulations section 1.1031(k)-1 a maximum of three target properties
without regard to their fari market values lmay be "identified."
(If any becomes unacceptable, a Notice of Revocation is needed.) If more than three properties are desired to be identified,
this is allowed if their combined fair market value at the end of the 45 day
period doesn't exceed 200 percent of the total fair market value of the downleg
properties. If you exceeded 200 percent, the exchange may be deemed fully
taxable, subject to the rules affecting property already received before the end
of the 45 days .
There
are additional rules under the regulations that deal with the number of
properties a taxpayer may identify that will not be covered here but that should
be referred to before executing a Section 1031 transaction.
Q
5. Can a taxpayer utilize Section 1031 when dealing with an owner-occupied
residence?
A
No. However, individuals sometimes
exchange one rental property for another planning to move into the acquired
property and, after living in it for two years, sell it and take advantage of
the capital gains exclusion of $250,000 for individuals and $500,000 for married
couples filing joint returns. This had sometimes occurred as soon as three or four years
after the acquisition. As of
October 22, 2004, this will no longer be possible.
Pursuant to the American Jobs Creation Act (signed by President Bush on
October 22, 2004), a property acquired in a 1031 exchange and later converted to
a principal residence must be owned for five years from the date of the exchange
before the owner can claim the capital gains exclusion.
So, in order to take advantage of a 1031 exchange and the capital gains
exclusion, the owner must both have used it as a principal residence for two
years and owned it for five years.
Q
6. Is it possible for a taxpayer to avoid ever paying tax on the gain deferred
in a Section 1031 exchange?
A
Yes. Since there is no limit to the number of Section 1031 exchanges that a
taxpayer can be involved in, a taxpayer can continue to defer the taxes due by
either holding on to the property or by further exchanging it with other
like-kind property until the taxpayer dies. When a taxpayer dies without having
sold or transferred the property in a taxable transaction, his/her estate will
not have to pay income tax on the deferred gain. The basis will be "stepped
up" to its market value at the taxpayer's date of death. As a result, when
the estate or heirs later sell the property, they will only pay tax on the
increase in value after the original taxpayer's death.
Q
7. Can personal (non-real estate) property be exchanged for other personal
property in a Section 1031 exchange?
A
Yes. Personal property can be exchanged for other like-kind (personal) property.
(See Question 11.)
Q
8. Can a partnership interest be exchanged in a Section 1031 exchange?
A
Generally not. The non-recognition of gain or loss rules do not apply to
transfers of most partnership interests. However, a partnership which owns
property can exchange the property for other like-kind property in a Section
1031 exchange. Exchanges involving a partnership are very technical and complex.
Parties interested in this area should consult a certified public accountant
(CPA) or tax lawyer experienced in this specialized field.
Q
9. Is there a particular way that a Section 1031 exchange must be structured?
A
No, an exchange can be structured in a number of ways. However, first and
foremost, a Section 1031 exchange should be structured by someone who has
expertise in this area. The exact structuring of an exchange depends on whether
the exchange will be simultaneous or delayed, the business practices of the
accommodator, (if any), the preferences of the parties' CPA, attorney, or other
tax advisor, and other factors. Structuring an exchange can be complex and
should be done only by someone experienced in the tax and financial aspects of
Section 1031 exchanges.
Q
10. To be eligible for a totally tax deferred exchange, must a taxpayer trade up
in equity as well as trade up in fair market value?
A
Yes. The fair market value of the upleg property must be equal to or greater
than the fair market value of the down leg property to avoid paying tax on any
gain. In addition, a taxpayer must receive equity in the upleg property equal to
or greater than the equity given up on the down leg property to avoid any
taxable "boot." Therefore, in an exchange, it is the equities of the
two properties that are exchanged. The equity is the property market value minus
any mortgages, liens or any other encumbrances.
Finding
two properties with equal equity is rare. It is possible for one party with
greater equity to, for example, take on an additional mortgage in order to make
the equities equal. Also, along with the exchange of the properties, one party
can give the other notes, cash, a car or other personal property to balance out
the equities.
In
general, a taxpayer should consider exchanging into a property with a higher
market value and a higher mortgage than the downleg to avoid paying taxes on any
gain. (See Question 12.)
Q
11. What is meant by a "like-kind" exchange?
A
Both the property transferred (downleg) and the property acquired (upleg) must
be like-kind. This means that real property may be exchanged for other real
property, or personal property may be exchanged for other personal property. For
real property, any property that is considered real property under State law
will qualify for an exchange for other real property, as long as the other
requirements are met. (See Question 2.) For example, an apartment house may be
exchanged for raw land that will be held for investment, or a single family
residential property that has been held for rental may be exchanged for a
shopping center, or any similar combination.
Q
12. What is "boot"?
A
If the taxpayer receives some cash or property in an exchange that does not
qualify for Section 1031 non-recognition of gain treatment, the non-qualifying
portion (unlike property) is called "boot" and will be subject to tax
based on the fair market value of the unlike property. Generally, there are
three different kinds of unlike property. These are:
cash;
other
unlike or non-qualifying property, which may either be real or personal property
(such as a house that the exchangor will occupy as a personal residence); and
net
mortgage or loan relief.
The
mortgage debt of the downleg property is considered unlike property and is
subject to tax. However, if the upleg is also subject to a mortgage, the amount
which is subject to tax is determined by the net mortgage relief. The unlike
property will be the balance of the downleg mortgage in excess of the balance of
the upleg mortgage. This rule will apply whether the property is acquired
subject to or with an assumption of a mortgage, or with a new mortgage. (See
Question 10.)
There
can be situations in which a taxpayer has net mortgage relief but also pays
cash. In that case, the net mortgage relief may be reduced by the cash paid in
determining the net unlike property received (boot).
On
the other hand, if a taxpayer receives cash and also assumes a loan amount
greater than that given up, the taxpayer may not reduce the amount of cash
received by the increase in the loan burden. Therefore, the full amount of the
cash received will be treated as unlike property (boot) in determining the
amount of recognized gain.
It
is clear that in order to avoid paying tax, boot must be eliminated. This is
commonly done by offsetting boot given against boot received. However, all forms
of boot may not be offset against each other. The following are some basic
rules:
Mortgage
boot received can be offset against mortgage boot given.
Cash
and property boot given, can probably be offset against mortgage boot received
and/or cash and property boot received.
Cash
boot received cannot be offset by mortgage boot given.
Note
that one "gives" mortgage boot by assuming an existing mortgage and
one "receives" mortgage boot by being relieved of the debt.
Q
13. What is an accommodator?
A
An accommodator is a term used to indicate the person or corporation who
facilitates the exchange. An accommodator has an active role in the execution of
the exchange. In general, the accommodator helps with the transfer of title and
holds the proceeds. The accommodator should be a party to the escrow, and
possibly to the acquisition agreement, too. The taxpayer should enter into an
"exchange agreement" (i.e., contract) with the accommodator specifying
what the taxpayer requires the accommodator to accomplish and the timing of the
accommodator's actions.
Q
14. Can the taxpayer's broker or attorney act as an accommodator for the
taxpayer's exchange transaction?
A
As a general rule, under the proposed regulations, a broker or attorney who
handles only the Section 1031 transaction for an exchange party may act as an
accommodator in the transaction without disqualifying the exchange. However, if
the broker or attorney is closely allied or bears a relationship to or has
represented the taxpayer more specifically (i.e., standing relationship as
broker or attorney for the taxpayer on previous occasions) the broker or
attorney will be considered a "related party" and this can disqualify
the exchange. Instead, the party should select an expert who is a
"qualified intermediary" and an "unrelated party," as
defined in the regulations. Some attorneys, CPAs, title companies, or others may
act as accommodators.
Q
15. What should a taxpayer look for in an accommodator?
A
A taxpayer should look for a knowledge of real estate and tax law, and evidence
that the accommodator is financially stable. questions a taxpayer should find
answers to, so as to avoid problems later on, include:
How
experienced is this person?
Is
it a corporation or an individual?
Is
it adequately solvent?
How
comprehensive is the exchange agreement (contract)?
Who
wrote the contract?
How
is the fee determined?
Are
the parties protected?
What
assurance is there that the right party will be paid when it's all over?
What
prevents the accommodator from taking the money and running off to Jamaica?
What
if the accommodator files bankruptcy or becomes insolvent?
Can
the accommodator give you a list of references from other exchanges the
accommodator was involved in?
Due
to the fact that an accommodator is intricately involved in an exchange, a party
should look for financial stability and experience when selecting an
accommodator.
Q
16. What about the risk of bankruptcy or insolvency by the accommodator?
A
The parties should structure the exchange so that their interest in the property
and/or funds is locked in in the event of a bankruptcy, and that other creditors
are prevented from affecting the validity of the transaction, such as by having
a "perfected security interest" in the property and/or funds, under
the Uniform Commercial Code. Other security arrangements are also possible.
If
an accommodator files for bankruptcy within 90 days of an exchange, the
Bankruptcy Court may be able to set aside the conveyance and reclaim the
property as part of the accommodator's bankruptcy estate. If this happens, a
party without a perfected security interest or other security arrangement risks
losing everything, depending on what assets and liabilities the accommodator has
during the bankruptcy.
Careful
selection of an accommodator can minimize, although not entirely eliminate, the
risk of bankruptcy or insolvency. Bankruptcy, and how to avoid its pitfalls, is
a complicated area of the law. Questions should be referred to an attorney
knowledgeable in this field concerning the consequences of the accommodator
filing bankruptcy or becoming insolvent.
Q
17. May an exchange party receive interest on the funds placed with the
accommodator?
A
Pursuant to Treasury Regulation section 1.103(k)-1(g)(5) the answer is yes.
The regulation provides a “safe harbor” stating that the
determination of whether the taxpayer is in actual or constructive receipt of
money or other property will be made without regard to whether the taxpayer is,
or may be, entitled to receive any interest or growth factor as part of the
deferred exchange. The safe harbor
applies, however, only if the taxpayer’s rights to receive an interest or
growth factor are expressly limited as stated in Treasury Regulation section
1.103(k)-1(g)(6). Taxpayers are
encouraged to see their tax advisor regarding compliance with the regulations
and other specific factors regarding receipt of interest in a 1031 tax deferred
exchange .
Q
18. What types of property do not qualify for Section 1031 exchange treatment?
A
Non-qualifying property includes cash, stocks, bonds or inventory. If these
things make up part of the exchange, the remaining property in the exchange can
still qualify for non-recognition treatment, but the non-qualifying property
will not, since it is boot. (See Question 12.)
Real
estate dealers may not exchange their real estate inventory under Section 1031.
In
addition, qualifying property must be "like-kind." (See Question 11.)
Q
19. Is there a minimum holding period for the property received in an exchange?
A
The law does not specify a particular holding period, except for exchanges
between related parties. However, both the property given up and the property
received must be held for productive use in a trade or business, or for
investment, or for production of income. As a result, if the exchangor sells the
property "soon," the IRS may determine that the property was not
acquired for investment or business use, but actually for resale. If the IRS
determines that the property was acquired for resale, then the benefits of
Section 1031 would be lost, and full tax liability would most likely follow. A
similar problem could occur if a rental house is acquired in an exchange and
then "soon" converted into a personal residence of the exchangor. Two
years is generally thought to be a safe period, but there are no specifics in
the law.
If
the exchange is between "related parties" (Internal Revenue Code
Section 267(b)), and a property received from a related party is disposed of
within two years after the transfer, any gain or loss that was deferred at the
time of the original exchange will now be subject to tax as of the date it is
transferred. An exception to this rule applies if the later transfer is due to
the death of the related party, an involuntary conversion, or other
circumstances which the IRS accepts as not done with the objective of tax
avoidance.
Q
20. What is the effect of commissions and other transaction costs paid on the
transfer in an exchange?
A
Costs such as commissions, documentary transfer taxes, escrow fees and other
transaction costs paid in connection with the transferred (downleg) property
reduce the transaction proceeds, and therefore reduce the amount of current or
future (deferred) taxable gain. Costs paid in connection with the acquired (upleg)
property are added to the basis of that property.
The
IRS has ruled that cash paid for transaction costs is to be treated as cash paid
in the exchange transaction. Therefore, the IRS ruling allows any transaction
cost paid in cash to reduce any cash received in the exchange in calculating the
amount of unlike property received.
Q
21. How are losses handled in a Section 1031 exchange?
A
There is no recognition of either loss or gain in a properly structured Section
1031 exchange. Both will be deferred until the property that is acquired is
later disposed of in a taxable transaction. If the taxpayer receives unlike
property together with like-kind property, gain will be currently recognized,
however, no loss from the exchange is recognized.
If
the taxpayer gives up unlike property together with like-kind property, loss is
recognized to the extent that the adjusted basis of the unlike property (other
than cash) transferred exceeds its fair market value.
The
amount of loss not recognized is reflected in the increased basis of property
acquired in the exchange because such property takes as its basis, the basis of
the property that was given in the exchange.
Q
22. What is a "Starker" exchange?
A
A "Starker" exchange is a Section 1031 exchange in which the transfer
of the downleg and the acquisition of the upleg do not occur at the same time.
Starker
v. United States which was decided in 1979, held that it was permissible to get
the tax benefits of Section 1031 when the upleg property is acquired after the
downleg is disposed of. The Starker case did not specify any time limits on
completing the exchange. However, Congress later added time limits for
identifying the upleg property and completing the exchange. These time limits
are discussed in Question 3.
Q
23. What commissions will a real estate broker receive in an exchange?
A
As with commissions in all types of transactions, this is a matter of contract
between the broker and the party or parties who will be paying the commission.
Commission obligations by one or more of the principals should specify, at a
minimum, when commissions will be paid, how much, and to whom.
(Under
California law, commission obligations must be in writing and signed by the
party who will be paying, if the transaction involves the sale,
"exchange," or lease for over 12 months, of real property. In
addition, if the property contains one-to-four residential units, the contract
which initially establishes or later increases a commission obligation must
contain the following language in at least 10-point boldface type: "Notice:
The amount or rate of real estate commissions is not fixed by law. They are set
by each broker individually and may be negotiable between the seller and
broker.")
Q
24. Are tax-deferred exchanges permitted under California tax law?
A
Yes. The authority is found in Sections 18043 and 24941 of the California
Revenue and Taxation Code which basically follows the federal law.
Q
25. Does this memorandum contain everything the reader needs to know about
Section 1031 like-kind exchanges?
A
No. This memorandum is not an exhaustive analysis of the law under Section 1031.
This memorandum is intended to give the reader a basic overview of Section 1031
exchanges. This memorandum is not meant to be used in place of professional
advice in any given situation. It is always recommended that the reader seek
professional advice before entering into a Section 1031 exchange.
Q
26. Where can additional information be obtained?
A
This memorandum is one of the many Legal Q&As, Legal Briefs, and other free
legal publications made available to REALTORS® by C.A.R. For a complete listing
of products and services available from C.A.R. visit C.A.R. Online at
www.car.org .
Readers
who require specific advice should review their facts with an attorney. C.A.R.
members may speak with an attorney, free of charge, by contacting C.A.R.’s
Member Legal Hotline at 213.739.8282, Monday through Friday, from 9:00 A.M.
until 6:00 P.M., or via C.A.R. Online at www.car.org .
C.A.R. members who are broker-owners, office managers, or Designated
REALTORS® can receive priority access to the Member Legal Hotline by calling
213.739.8350 or via C.A.R. Online .
General
correspondence can be addressed to legal_hotline@car.org or: